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Loan portfolio stress testing for financial institutions in the wake of COVID-19

Apr 14, 2021

Are you thinking about how COVID-19 will impact your loan portfolio, your earnings and your capital position? Do you continue to see warnings and have concerns regarding increasing credit risk as a result of the pandemic? 

While there remains no broad mandate for smaller financial institutions, regulatory agencies have long encouraged the use of stress testing to identify and quantify risk in loan portfolios. Loan portfolio stress testing is a risk management “best practice” that is here for the long term. 

Because COVID-19 has had such a significant impact on the economy, it’s a good time to consider a stress test. If your institution has not yet ventured into this arena, now is the time to begin.Understanding the areas of lending that pose the greatest risk to the institution will help you navigate the uncharted waters of the pandemic and post-pandemic worlds.

COVID-19 stress testing considerations

COVID-19 was a low probability, high consequence event. Few organizations expected it to happen, and that left a lot of companies largely unprepared. As a result, credit risk has increased.

The government stepped in with a number of stimulus and mitigation efforts, which have helped stave off the worst of the economic impact from an interest rate sensitivity, liquidity and credit risk perspective. But the question remains: Are we without that risk, or has the issue really just been kicked down the road? We don’t know exactly how it's going to play out.

The adverse economic effects have varied widely by industry sector and geography, and financial institutions need to get a handle on how that has affected them. Having a good sense of the macroeconomic factors that are impacting your borrowers can go a long way. 

Regulators understand that stress testing will be a challenge right now. No one expects that it will be easy to formulate all the assumptions that you need to put in any model. What you know from the past is not necessarily going to apply, and now may be the time for a fresh perspective.

Keep in mind those industries that are showing significant stress. Drill down into your individual borrowers and assess them to make sure they're not being impacted by something you’re not readily aware of. 

Also, consider how forbearance and other mitigation efforts come in play. They may affect some borrowers and not others, but you need to keep those in mind as you go through this exercise. 

What is stress testing?

Stress testing is a management tool that allows a financial institution the ability to forecast its financial position over a specified time horizon, using different scenarios of increasing levels of stress. Typically, if you're doing portfolio stress testing, you start with a baseline that would be your norm and then you would apply an adverse and then a more severe scenario and see how that affects your portfolio.

An important element of stress testing is its forward-looking quantitative evaluation. It's not a judgment call — it definitely shows you, by the numbers, what a particular level of stress would cause within your financial institution.

Institutions have historically monitored and analyzed lagging risk indicators, things like loan delinquencies, non-performing loans, restructures and charge offs. These types of indicators provide after-the-fact evidence of credit quality issues. 

Although thresholds for lagging indicators are good, once you reach the ratio that you have as a limit, it’s very difficult to make adjustments and course corrections. That’s why a forward-looking approach is a hot item for regulators. More forward-looking analysis is expected now. 

Types of loan portfolio stress testing

There are a few common methods used to stress the loan portfolio. Common approaches include: 

  • Transaction stress testing: Estimates potential losses at the loan level by assessing the impact of changing economic conditions on a borrower’s ability to service debt.
  • Portfolio stress testing: Identifies current and emerging risks and vulnerabilities within the loan portfolio by assessing the impact of changing economic conditions on borrower performance, identifying credit concentrations and measuring the resulting change in overall credit quality and the financial impact on earnings and capital.
  • Segment stress testing: Evaluates how a certain portfolio segment may respond to different levels in a key performance metric.
  • Enterprise level stress testing: Considers multiple types of risk and their interrelated effects on the overall financial impact under a given economic scenario. These risks include credit risk within loan and securities portfolios, counterparty credit risk, interest rate risk and changes in liquidity position.
  • Reverse test testing: A method under which the bank assumes a specific adverse outcome and then deduces the types of events that could lead to such an outcome.

Don’t worry so much about the form as much as the substance of the stress test and whether you are able to capture the risk in the portfolio. The end objective is to build a meaningful, routine practice of assessing risk and then then incorporating that insight into your financial institution’s strategic plan and capital planning. 

Your next steps

Stress testing is a growing regulatory expectation and can help you understand critical vulnerabilities and identify potential impact on your capital. Contact us to learn about our stress testing model validation services.

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Janeen Combs
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Karen A. Mitchell
Senior Manager, Risk Advisory Services
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